Investors' Optimism Declines on Worries About U.S. Economy

PRINCETON, NJ -- Last week, the Fed took dramatic action as it lowered interest rates and signaled to the investment community that it recognized the seriousness of the current risk re-evaluation taking place in the global credit markets and on Main Street. Not surprisingly, the Fed's action sent the stock market soaring, commodity prices surging, the value of the dollar plunging, and longer-term interest rates raising, thus making the yield curve steeper. Unfortunately, neither the Fed's actions nor the resulting fallout directly addresses the economic factors that are currently dragging down investor optimism and the U.S. economy.

Investor Optimism Fell Prior to Rate Cut

A new UBS/Gallup Poll (conducted Sept.1-16, 2007 -- just prior to the Fed interest rate cut) shows investor optimism declining for the fourth consecutive month. The Index of Investor Optimism now stands at 68 points -- down five points from August and at its lowest level of the year. The Index is conducted monthly and had a baseline score of 124 when it was established in October of 1996.

The decline in investor optimism came along the Economic Dimension of the Index -- a score that fell seven points to -2 for the month of September. This is the lowest level of optimism in regards to the economy since August 2006 when it stood at -1.

In sharp contrast, investors remained hopeful about their individual investment portfolios -- even before the Fed cut rates. At that time, the Personal Dimension of the Index increased by two points in September to stand at 70. The continued strength of the Personal Dimension suggests many investors believe they will be able to maintain their current investment portfolio returns over the next year, even as the U.S. economy weakens.

While most investors remained sanguine about their investment portfolio returns, 34% of investors said that recent disruptions in the financial markets have made them re-evaluate their investment portfolios. Of those who have made a re-evaluation, 58% say they are holding more cash or cash equivalents, 43% say they have reduced their investments in complicated financial instruments such as mortgage-backed securities, and 20% say they have reduced their investments outside the United States.

Investors Have Many Reasons to Worry

Despite the sharp run-up in oil prices over recent weeks, investors' concerns about higher energy prices remained essentially unchanged in September. Sixty-five percent said they believe energy prices are hurting the current investment climate a lot. This is a slight increase compared to the 64% who felt this way in August and a decrease from the 70% who held this view in July.

Housing and real estate worries remain second only to energy prices as an investor concern in September, with 55% of investors believing the potential for a housing or real estate crash in some local markets is hurting the investment climate a lot. This is essentially the same as the 54% who felt this way in August. However, this is a sharp jump from the 41% who felt this way in July. This change represents the highest level of concern about housing since October of 2005, when the tracking this particular issue began.

Investors appear to see no bottom in sight for the housing and real estate markets at this point. Eighty-one percent said they believe economic conditions in the residential real estate market nationwide are getting worse. This figure is largely the same as the 80% who felt this way in August, but it is up from the 71% who held this view in July. Sixty-five percent of investors say conditions in their local real estate markets are worsening. This is up from 62% in August and 60% in July. Investors also fear the problems in the subprime mortgage market will spread with 63% feeling there will be a spillover into the overall mortgage market. Only 27% feel it will be contained.

The Consumer Credit Crunch Is Intensifying

Investors feel the credit crunch is squeezing the consumer even tighter with 68% saying it is harder for Americans to get credit now than it was three months ago. This is up from the 51% who felt this way a month ago. In this regard, 44% now believe the consumer credit crunch is hurting the investment climate a lot.

Can the Fed "Fix" the Consumer Credit Crunch?

The current consumer credit crunch is significantly different than many such events in the past. For example, long ago, interest rate ceilings -- a legacy of the Great Depression -- limited the interest rates that financial institutions could pay for deposits. As the Fed raised interest rates above these deposit rate ceilings, money flowed out of local financial institutions creating a consumer credit crunch that severely limited the availability of housing and auto loans to consumers and small businesses. A consumer credit crunch might result from double-digit interest rates that limit the ability of consumers to qualify and pay for credit. In both cases, higher interest rates reduced the availability of consumer and small-business credit. As a result, lower interest rates could solve the problem by simply making money available at a lower cost, thereby giving monetary policymakers a great deal of influence over the economic cycle.

The current credit crunch has much different roots. Over the past several years, consumer credit has not only been relatively inexpensive historically, but also readily available on the basis of extremely lax underwriting standards. Securitization acerbated this situation as the holders of consumer and business debt were separated from the originators and underwriters of these loans. When the subprime mortgage debacle exposed a significant portion of recently originated consumer debt as being poorly underwritten and subject to substantial losses, investors, lenders, and regulators began re-evaluating their investment portfolios and underwriting standards. As noted earlier, many investors in the recent poll said they have significantly reduced their investments in securitized investment vehicles and decided to hold more cash and cash equivalents. Unfortunately, lower interest rates cannot easily solve this risky re-evaluation situation.

The Fed's "shock and awe" attack on interest rates will help investor psychology and ease the pain as lenders and investors adjust to more stringent consumer and business underwriting standards. It might also help some homeowners as their adjustable rate loans are up for renewal. However, many consumers and businesses that have had credit readily available to them in the past are still going to find it difficult, if not impossible, to get credit in the months ahead. The reality is that the Fed simply has a much-reduced ability to deal with the current credit crunch than it has had with those of the past.

Further, the Fed's action has come at a steep price in terms of a sharp drop in the value of the dollar and significantly higher longer-term interest rates. As a result, it will not be surprising if -- despite the Fed's best efforts -- the three in four investors (74%) who described the current U.S. economy as being in a slowdown or recession in the September UBS/Gallup Index of Investor Optimism Poll actually increases during the months ahead. Still, investors may become even more optimistic about their investment portfolios as a result of lower interest -- but they will be doing so by betting on the global economy, not the U.S. economy.

Survey Methods

Investor results are based on telephone interviews with 801 investors, aged 18 and older, conducted Sept. 1-16, 2007. For results based on the total sample of investors, one can say with 95% confidence that the maximum margin of sampling error is ±4 percentage points.

In addition to sampling error, question wording and practical difficulties in conducting surveys can introduce error or bias into the findings of public opinion polls.

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